III
Let us take bank credit first. In any situation where
banks hold a larger amount of government securities
than required under the SLR obligation, they can
always off- load a portion of these securities to the
RBI, if not directly then at any rate at the margin by
not picking up fresh government debt (which ipso facto
would then devolve upon the RBI in its role as the
underwriter of this debt). It follows that whenever
banks hold excess government securities, since these
can be traded for reserve money but are not, the
credit market must be a buyers' market, i.e. there
must be a shortage of demand for credit from
worthwhile borrowers. Credit cannot be
supply-constrained in such a situation.
This is precisely the case in India today. Indeed the
Economic Survey 2000-01 states this quite clearly:
"The position changed with the inflows under IMDs in
November 2000, which led to a sharp increase in the
RBI's net foreign currency assets. The resultant
generation of liquidity facilitated a sharp reduction
in RBI's net domestic assets by enabling the RBI to
off-load from its portfolio a significant portion of
Central government dated securities to the market"
(p.55). If credit had been supply-constrained in the
economy, then the "market" which includes the banking
system would never have moved into government
securities.
One remark of the PMEAC may be construed as a
counter-argument to what has just been said, but that
remark itself constitutes yet another logical
contradiction in the PMEAC's argument. The PMEAC
report says: "In recent years the government has been
borrowing at around 11 percent when inflation averaged
around 5 percent. This implies real interest rates of
6 percent for government borrowing, which means that
private sector financing has to be at real interest
rates of 8 percent or so for the best corporates and
correspondingly higher for others. With such high real
interest rates, private investment is bound to be
choked off, which is exactly what has happened." This
argument would appear to contradict my argument that
"excess holding" of government securities by banks can
occur only when credit is demand-constrained, since it
believes that this "excess holding" is because of the
attractiveness of government securities.
This argument of the PMEAC however is logically faulty
for two reasons: first, a 6 percent real rate of
interest on government securities can correspondingly
increase the interest rate on private securities only
under certain circumstances. An obvious one is if the
supply of government securities is infinitely elastic
at this rate. If the supply is only a finite amount,
then after this amount has been picked up, banks
having additional resources will start picking up
private securities at 6 percent or even lower real
rates (as long as they cover "marginal cost"). A 8
percent floor real rate for private securities can
operate only if banks' resources are limited relative
to the supply of government securities. But if that
were the case then the Reserve Bank (whose Governor is
a member of the PMEAC) should be deemed to have
committed a great disservice to the nation by
offloading "from its portfolio a significant portion
of Central government dated securities to the market."
The RBI cannot gratuitously increase the stock of
government securities in the market and then complain
that there are too many government securities in the
market! Attributing sense to the RBI must therefore
lead to the conclusion that it offloaded securities
because banks had extra resources owing to
insufficient demand for credit from worthwhile
borrowers. In other words, banks' holding of excess
government securities suggests that credit is not
supply-constrained.
Secondly, the interest rate comparison in the PMEAC
report is wrong, as the following example will show.
Suppose for simplicity that banks have only three
assets, cash, government securities, and loans to
commercial enterprises, and suppose they are required
to maintain 10 percent of their assets as cash and 25
percent as government securities. Suppose also, to
start with, that they hold Rs.10 of cash reserves,
Rs.29 of government securities, and Rs.61 of credit,
i.e. they are maintaining the cash-reserve ratio but
have "excess holding" of government securities. Then
by selling Re.1 of government securities to the RBI,
they can, collectively, expand their assets to Rs.11
of cash, Rs.28 of government securities, and Rs.71 of
credit, provided there is plentiful demand for credit.
If the number of banks is small and profit prospects
significant, they would indeed be expected to
co-operate to realise these prospects. Hence if r
denotes the real interest rate on government
securities and r' the rate on credit, then banks in
the above example would get rid of excess holding of
securities if 10 times r' exceeds r. More generally,
if the cash-reserve ratio is denoted by c, banks would
never hold excess government securities as long as
r'/c exceeds r. The real comparison to make in other
words is not between r' and r, as the PMEAC does, but
between r'/c and r, where the former must win. It
follows then that "excess holding" of government
securities will never be resorted to if adequate
credit demand is forthcoming.
The fact that the banking system in India has been
holding excess government securities implies then that
credit has not been supply-constrained, in which case
one of the assumptions underlying the PMEAC argument
collapses. The other assumption, namely that the real
economy is supply-constrained, is even more palpably
wrong. When the country has 45 million tonnes of
foodgrain stocks, when industrial growth is slowing
down, when the existence of a demand constraint over
vast sectors of Indian industry is recognised even by
the Economic Survey, it is indeed sad to see that the
group of highly distinguished economists which
constitutes the PMEAC has put forward an argument
which assumes Keynesian full employment!
Since our system is demand-constrained both in credit
and commodity markets, the basic assumptions of the
PMEAC report break down. Thus, no matter which of its
alternative versions we consider, the proposition that
the real interest rate is high because of the high
levels of fiscal deficits is erroneous: the theory it
invokes for itself is in each case untenable; and the
conditions under which it might hold empirically, if
inserted within a tenable theory, are far removed from
those that are actually obtaining.
